1. Field of the Invention
This invention relates to developing risk management tools for manufacturing environment to achieve market efficiency
2. Related Field
The globalization of market economies is changing the way business in general, and manufacturing in particular, are conducted. In addition to the usual supply and demand factors, the huge inflows (and outflows) of capital from one market to another are creating a much larger market swing than the predictable seasonal or cyclical changes that occur from time to time. This stems from significant inter-manufacturing trades that take place routinely around the world. In a given environment there are risk elements that in normal circumstances are assumed to be known among the parties involved in the line of supply chain. Buyers and sellers in manufacturing sector expect a fixed price once an order is placed. They assume that the market conditions including currency and interest rates remain static during that period or if not each party is responsible for the risk involved.
In today's practices purchases and sales are made between any two parties in the old fashion way. A handshake. Such arrangements, known as forward contracts, bear a fixed price and promised delivery. A vast majority of these contracts remain exposed to risk; its significance has recently come to light mainly due to globalization of business activities. The manufacturing community has not yet addressed the question of shifting risk from tangible assets (the inventory) to paper trading (securities).
Manufacturers are aware of the risk involved in building up inventory if the market goes soft because an untimely liquidation can be costly. Those who do not maintain inventory assume a similar risk. A sudden increase in the price of raw materials may cut into their profit. Minimizing the cost of storage or inventory, however, provides a strong and logical economic justification, considering the cost of money alone. The application of risk management will accommodate the manufacturers' inventory dilemma as well as stabilizing prices. It will end the boom and bust cycle by creating price stability in basic commodities. It also provides price transparency which helps market to become more efficient. Most significantly it lowers the cost to consumer by creating more competitive business environment
The Risk Factor
Risk is an element of uncertainty. Generally risks are typified as speculative or inherent; they are either static or dynamic. Risk management is a tool for removing the lack of knowledge about the type of risk. Risk is normally reduced or avoided by shifting it from, say, consumer to risk taker. A major risk in business is market risk. The market risk may generally be perceived as price, interest rate and currency exchange rate. Any movement in a price or rate will be undesirable to some market participants. Financial market innovations have sharply reduced many liquidity risks in recent years. Risk management, as a tool, can help minimize possible financial losses resulting from price changes. This technique is extensively used in futures industry. In all these cases formal exchanges facilitate the risk management by allowing the producer and consumer to transfer their business risk to risk takers.
Present Practices in Risk Management
Risk management has been, of course, addressed in some businesses through traditional commodity exchanges. The mechanism of risk management is generally based on certain products representing a broad spectrum of industries ranging from agricultural to mining and financial. At present a limited number of products traded in such exchanges serve as bench mark for pricing the underlying commodity of a given industry. Crude oil is an example for petroleum industry. The market liquidity is then largely dependent on such selected product It should be noted that the specific product selected even though fully researched does not guarantee of being the right one and many tries are made before a successful launch of a product is proven. This interpretation of product selection is generally based on criteria practiced in traditional commodity exchanges. The criteria for product selection, presently tailored for floor trading model, include size, volatility, source of public information (such as supply and demand), existence of dealer community and most important, the liquidity factor which is considered an essential element for risk management.
Based on such products financial instruments are designed. They are then used as the medium to shift financial risks. This implies that certain physical assets should be translated to financial instruments. The economic value of commodity trading, therefore, lies in its ability to transfer risk from the hedger (producer and consumer) to investors or risk takers. This is the basis for stabilizing price which accommodates a smooth supply chain within, say, the manufacturing community. The greatest achievement of financial instruments is to free, for example, manufacturer or supplier from commitment to holding contract until the goods are delivered or received at the expiration date. They can be traded as any other traditional securities
Problem of Developing Products
The extension of random product selection to other industries, as means of risk management tool, is difficult and costly due to several factors. Firstly, the number of products become limitless in, say, manufacturing as the value-added products continue to expand. Secondly, the dynamics of industry cause continuous changes in product specification and most important, the global trade requirements will render the existing rigid exchanges impractical for handling large number of products effectively. In contrast to standard contracts, non-standard contracts pose a higher risk for exchanges than standard contracts. Risks include those with bad credit (e.g., due to bankruptcy or foreclosure), non-performing contracts (e.g., late or non delivery of goods or non payment).
In view of the above; therefore what is needed is a system, method and computer program product for flexible products and contracts adaptable to risk management. Such a system would create a “marketplace” in which producers and consumers of these financial instruments as a means for managing their risk.